You may have noticed some posts on this blog and elsewhere last week about what some term the Obama Own-To-Rent program. Essentially, the idea is to permit homeowners who lose their house to foreclosure to remain in the property as renters.
I’m not going to rehash the program or the differences of opinion; you can find links to my thoughts here, which includes links to previous posts on the subject. I think that it’s generally a terrible idea while Felix Salmon and others support it (here).
Now as luck would have it, I received an email from a fellow by the name of Ralph Liu last week. Ralph has been working on something along the same lines but one that avoids foreclosure. He has been hard at it for several years and took the time to not only provide me with a lengthy explanation of his ideas along with links to his websites but also spent a considerable amount of time on the phone explaining some of the finer details. At the end of this article you will find a summary of Ralph’s credentials. As you can see, he is an accomplished man.
Ralph’s program is called SwapRent. In very simple terms it allows a homeowner to monetize his future appreciation. The applications as it applies to the current crisis of foreclosure as well as to future home purchases are numerous.
A good way to understand the program is to think about shared appreciation mortgages. This type of mortgage gives the lender a portion of the future value of a house in exchange normally for a lower interest rate on the mortgage. Some have suggested that shared appreciation mortgages might be used to induce banks to make deep principal modifications of nonperforming mortgages. Give them a share of the future equity for forgiven principal.
Shared appreciation mortgages have been around for some time and have never really taken off for a couple of reasons. Among them, once in place it’s very difficult to unwind the transaction. They tend to be permanent. Additionally, it’s difficult for the bank and homeowner to reach a consensus on the value of the future equity and the bank tends to be stuck with its position, there’s no market for the future value.
SwapRent addresses all of these issues.
The equity given up in a SwapRent transaction is meant to be priced and traded in a secondary market, thus giving both the homeowner and the bank a transparent, third party valuation. The homeowner is not locked into a fixed maturity as the SwapRent contract provides for early termination and the bank or other middleman is free to sell their equity piece in the secondary market thus freeing up capital. SwapRent also allows the homeowner to choose the percentage of future equity he wants to swap and to alter that percentage during the life of the contract.
It might be useful to take a really basic look at how a transaction might come together. Let’s say a homeowner has a house that’s currently valued at $200,000 and for arguments sake they owe $190,000 so they have $10,000 in equity. The bids in the secondary market for the equity piece of a SwapRent mortgage assume that the house will be worth $250,000 in five years. In exchange for giving up a potential $50,000 in future appreciation, he receives monthly payments from the buyer of the equity that would be approximately $750 per month.
So, how do you settle this in five years? The first thing that needs to be done is to establish the value of the property. This can be accomplished by referring to a nationally recognized index, by an appraisal or in the case of the sale of the house by the sales price. In our example, let’s assume that the parties agreed to an appraisal and the homeowner will continue to live in the house. At the maturity date, they he will have to come up with $50,000 either out-of-pocket of via refinancing to pay off the holder of the equity piece. Keep in mind that the owner hasn’t forfeited his $10,000 of original equity and he has received an appreciable sum of money in the interval, presumably to his benefit.
What happens if the house appreciates faster than expected? In that case the buyer of the equity piece is going to make more money than expected and the homeowner will be on the hook for more than $50,000 but again, the house has the equity in it to settle the transaction.
If the market should go south and not appreciate or appreciate slowly than the buyer of the equity piece loses and the homeowner pockets an outsized amount of money.
The homeowner is free at any time to cancel the transaction and is only liable to the buyer of the equity slice for whatever appreciation that might have accrued to that point. If his finances have improved to the extent that he doesn’t need the extra income or he sees appreciation picking up he can simply call the game off at his discretion.
So what are the applications for this plan? There are lots and I’ll talk about some of them in a follow-up post but for now consider two types of distressed borrowers. Those under water and those who are about to lose their house due to insufficient cash flow.
Using SwapRent, banks that hold underwater mortgages can be induced to make larger modifications to principal balances. By bringing the loan amount down to current market values and offsetting some of their loss of principal with a share of the equity in the property, it might be possible to get the borrower out of the upside down position at a cost to the bank that is less than they would incur in foreclosure. Using the secondary market for SwapRent equity they could monetize the asset. In a normal shared equity arrangement they have an asset with an uncertain future value.
One of the persistent problems with modifications has been that many homeowners have accumulated so much debt that even if the housing ratio is brought down to 31% via interest rate reductions, the total leverage ratio is still too high to safely modify the loan. SwapRent could be used with these borrowers to provide an additional source of income to offset their other debt payments and allow the modification to proceed. Due to its early termination feature, homeowners that find their financial situation has improved and no longer require the extra money can opt out of the program.
Those are just a couple of ideas and I suspect that if you let your mind wander a bit you can come up with some others. It’s a remarkably flexible concept with multiple applications.
This idea is going to run straight into the current meme that the consumer needs very simple financial products and this is, therefore, inappropriate. I don’t know how to counter that argument other than to say, look at the benefits and see if they outweigh the risks.
I like the concept and I would like to hear what you think about it. I’ll post some more on this topic but I want to get the basic idea out there and get some discussion going. Give me some feedback.
Ralph Liu Background
Before I get into the details, let me tell you a bit about Ralph Liu. He’s not some amateur armchair economist. Ralph has had a distinguished business career that includes stints with Morgan Stanley, JPMorgan Chase, and Equitable Life. He holds an MBA from Wharton and as Executive Vice President and Chief Investment Officer of Everbright Bank where he introduced the first ever RMB-denominated interest rate swap to the Beijing inter-bank market and designed and implemented the first long-term fixed rate mortgage product for China.
I should note that this concept is not new. As I mentioned Ralph Liu has been working on this for some time. If you Google “swaprent” you will come up with previous articles and comments on the topic.